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The critical success factors for commercialising

microfinance institutions in Africa

Joséphat Mboya Kiweu

Dissertation presented for the Degree of Doctor of Philosophy

at Stellenbosch University.

Promotor: Professor Nicholas Biekpe

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Declaration

By submitting this dissertation electronically, I, Joséphat Mboya Kiweu, declare that the entirety of the work contained therein is my own, original work, that I am the owner of the copyright thereof (unless to the extent explicitly otherwise stated) and that I have not previously in its entirety or in part submitted it for obtaining any qualification.

Joséphat Mboya Kiweu 27 October 2009

Copyright © 2009 Stellenbosch University All rights reserved

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Dedication

This work is dedicated firstly to my wife (Cecilia Wambui) and children (Kitonga, Keli na Mwende) who know the pain of being left alone. This is my gift of patience, long-suffering, enduring faith and love to you. You have endured much suffering; share in my happiness now. To God all the glory, for thus far He has brought us together. For my family, I am finally yours again. In order to write this manuscript, I tried to forget everything (including you) and had to take my mind far away from home, to a wonderland and my highest aspirations because I strived to realise this dream. You believed in me as I tried to follow my dream, and now there is nothing more to yearn for.

Secondly, I dedicate this dissertation to the poor in Africa, for they suffer so (Proverbs 14:20). Their plight forced me to search for an alternative financing mechanism. You share the same lot – you hope, wait and dream for a better tomorrow from your Creator (Proverbs 22:2). My wish is that this manuscript will bring relief and cause you to leap for joy. I only trust that you will not make my walk be in vain (Proverbs 20:12-13).

For the poor and needy in Africa, I make public ‘the way’ in this study, as an alternative to donations. You must now walk this way, but do not forget to watch out for the potholes – for there are plenty in Africa. It was a painstaking job to study microfinance, as it was not visible at all times! But I searched for the seed of good in all adversity, criss-crossing the continent, in thoughts and physically, during the course of this study. And now, such as I have, I give to you Africa (Acts 3:6). This study is indeed yours as it contains nothing but your true experience: the author became inspired to do the study while in Kenya, wrote the proposal in Tanzania, conceptualised the study in South Africa, wrote some of the chapters in Ethiopia, Uganda, Mali, Kenya, Nigeria and Benin and concluded his last thoughts in Senegal, Dakar. As the author struggled through these writings, he remembered one thing that encouraged and motivated the going, namely that, “success will not lower its standards to us – we must raise our standards to success” (by Rev. Randall R. McBride, jr.). This is what Africa must surely do – raise your standards to success to get out of impoverishment and meet with much money! For money answers all problems (Ecclesiastes 10:19).

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Acknowledgements

I wish to express my sincere appreciation to my promotor, Professor Nicholas Biekpe, for his valuable motivation, comments and advice in the preparation of this dissertation. In addition, special thanks go to my wife, Cecilia Wambui, whose familiarity with the problems of after-school studies or ngumbaru studies (as it is called in Kenya) and patience, like of a mother waiting for a son gone hunting, was helpful during the early days and several phases of this undertaking. What a patient and understanding wife! Without her understanding and co-operation, this study could not have been completed. Her heartfelt concern, pressure and many prayers kept me going in a far-away country.

Many thanks also to the members of the University of Stellenbosch Business School (USB) Doctor of Philosophy (PhD) Colloquium for their valuable input during the conceptual development of this study. I will remember their suggestions forever. My sincere gratitude also goes to Professor Eon Smit, the Director of the USB, who not only played a key role in providing direction and advice on research methodology, but also encouraged and inspired me to make surmountable progress. I will not forget my PhD colleagues (Chipo Mlambo, John Morrison and Glen Mansfield) for their encouragement.

I also want to thank all the USB staff who contributed in different ways. In particular, many thanks to Prof G.A. Schoombee, Prof Wim Gevers, Dr Babita Mathur-Helm, Prof Louis Fourie and current Head of Doctoral Programme, Prof Hein Oosthuizen, for their valuable advice. This dissertation would not have been possible without their hard work and efficiency. This list can be endless, but I think you all know that it takes much more than one head to erect a great architectural building. The views, findings, interpretations and conclusions expressed in this dissertation, and any errors are entirely the responsibility of the author, and should not be attributed to the USB or its staff. Most importantly, my sincere gratitude to the experts from the Centre for Statistical Consultation for their invaluable effort to bear with me while analysing this data. Special thanks to Dr Martin Kidd and Prof Daan G. Nel of Stellenbosch University Main Campus.

Last but not least, I would like to thank my parents for their moral support, encouragement and love in my struggle for knowledge.

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Abstract

Uncertainty of continued donor funding poses a risk to microfinance operations worldwide, and this study explores the circumstances under which African microfinance institutions (MFIs) will consider commercial funding as a viable alternative source of funding. This research aims to identify the factors that are associated with successful access to private capital for pro-poor financial institutions. It examines the suitability of new opportunities for accessing fresh capital by MFIs for development and poverty reduction using commercialisation as an option. In a world awash in private capital, it is vital to harness the power of the private sector to solve key development challenges (World Bank, 2007). As microfinance institutions grow, they increasingly find themselves in need of additional capital to finance expansion of services to cover more poor communities.

The study undertook a cross-country data analysis of 103 microfinance institutions to help provide understanding of the critical success factors that underpin successful access to commercial capital. The study also tested the hypothesis on the viability of commercial finances, and developed and tested a commercialisation success model for tapping commercial funds. The prediction model based on firm-level data from a sample of 21 African countries between 1998 and 2003, aims to minimise chances of failure and act as a screening system by investors as well as a self-assessment tool for MFIs intending to seek commercial capital. On examining the direct and indirect impact of firm-level success factors on commercialisation, the study identified key predictors of success and guidelines for MFI financing’s integration with the larger financial system. The study finds that certain critical success factors (CSFs) define minimum pre-conditions for microfinance institutions considering commercial funding as an alternative sourceof finance. There is evidence to suggest that the desire to tap into the capital markets and capacity to link with commercial investors is a realisable vision for African MFIs. The research evidence is instructive of widened financing options for MFIs and capacity to relax growth constraint in the industry. Based on the CSFs, the study suggests how MFIs can break free from 'captive' donor funding as a necessary platform for the switch to commercial finance in the industry. However, the findings also suggest the need for MFIs to satisfy the interests and requirements of prospective commercial investors to overcome new challenges.

In particular, the results show that the extent of organisational formalisation and transparency in financial reporting are absolutely essential in drawing commercial lenders to invest in microfinance. In addition the study establishes the reasons why traditional approaches to financing microfinance cannot work any longer. There are some concerns on mission drift; in particular whether the poor gain from commercialisation, and under what circumstances their interests are taken care of in order to preserve the long-term social value of microfinance as a poverty reduction strategy.

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The study was carried out based on a rather limited time series data.However, the number of firms and the diversity is considered adequate for the study, as well as sample representation across Africa. The study also used views of 'thought leaders' as the source of information. Other personnel calibre may have had different suggestions. Perceptions were drawn from commercial lenders/investors of microfinance programmes based in Africa. Needless to say, any generalisation of CSFs beyond the African microfinance context should be made with caution.

This study is probably one of the first attempts to explore the possibility of a linkage between microfinance and capital markets and it will be of interest to MFIs, commercial banks, international donors and investment funds with an interestin investing in the microfinance industry.The findings suggest that the speed of increase in financial leverage per country depends as much on the dynamism of the market, as it does on the level of development of the finance sector. The results indicate that commercial investors will be attracted by good financial returns and administrative efficiency (return on assets, cash-flow adequacy and operating expense ratio), transparent reporting and information disclosure and clarity, as well as low inflation levels. Investors will also be looking for larger, regulated and profitable MFIs with a low-risk profile for their investment portfolios.

The study found strong support to the hypothesis that the commercialisation index (CI) is a better measure of successful commercialisation than the LMA (leverage multiplier added), given the variables used. In all cases, compelling evidence shows that the CI has more explanatory power and is an accurate predictor of two-year success in commercialisation as examined by logistic regression. These results suggest that the superior predictive abilities of the CI commercial rating rule could be explored to guide screening efforts for winners, investment decisions and other binary classification investigations. Specifically, the model can be useful in guiding successful commercialisation schemes in Africa because it provides MFIs with a structured approach for achieving sustainable commercial microfinance.

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Opsomming

Onsekerheid oor volgehoue skenkerbefondsing is ’n risiko vir mikrofinansieringsinstansies wêreldwyd, en hierdie studie ondersoek die omstandighede waaronder Afrika se mikrofinansieringsinstansies (MFIs) kommersiële befondsing sal oorweeg as ’n lewensvatbare, alternatiewe bron van befondsing. Hierdie navorsing poog om die faktore, wat met die suksesvolle toetrede tot private kapitaal van pro-arm finansiële instellings geassosieer word, te identifiseer. Dit ondersoek die gepastheid van nuwe geleenthede vir MFIs om vars kapitaal te bekom en as ’n opsie te gebruik vir ontwikkeling en die vermindering van armoede deur kommersialisasie. In ’n wêreld met oorvloedige bronne van private kapitaal is dit lewensnoodsaaklik om die krag van die privaatsektor in te span om kern ontwikkelingsuitdagings op te los (World Bank, 2007). Soos mikrofinansieringsinstansies groei, het hulle ’n toenemende behoefte aan addisionele kapitaal ten einde die uitbreiding van dienste te kan finansier en om meer arm gemeenskappe te kan bereik. Die studie het data komende van 103 mikrofinansieringsinstansies uit verskeie lande ontleed om begrip van die kritiese suksesfaktore (KSFe), wat suksesvolle toegang tot kommersiële kapitaal onderskraag, te verkry. Die studie het ook die hipotese oor die lewensvatbaarheid van kommersiële finansiering getoets, en ’n model vir kommersialisasie-sukses ontwikkel en getoets om kommersiële fondse te bekom. Die voorspellingsmodel, wat gebaseer is op maatskappy-vlak data van ’n groep van 21 Afrika lande tussen 1998 en 2003, poog om die kanse op mislukking te minimeer en te dien as ’n siftingstelsel vir beleggers sowel as ’n selfondersoekmiddel vir MFIs wat beplan om kommersiële kapitaal te bekom. Deur die direkte en indirekte impak van maatskappy-vlak suksesfaktore op kommersialisasie te bestudeer, het die studie sleutelvoorspellers van sukses asook riglyne vir die integrasie van MFI finansiering met die groter finansiële stelsel geïdentifiseer. Die studie bevind dat sekere KSFe minimum voorvereistes vaslê vir MFIs wat kommersiële befondsing as ’n alternatiewe bron van finansiering oorweeg. Daar is bewyse wat daarop dui dat die begeerte om toegang tot die kapitaalmarkte te verkry en die kapasiteit om met kommersiële beleggers te skakel ’n realiseerbare visie vir Afrika MFIs is. Die navorsing lewer insig wat aanduidend is van breër finansieringsopsies vir MFIs, en wat die beperkinge op groei in die industrie verslap. Gebaseer op die KSFe, stel die studie voor hoe MFIs uit die houvas van skenkerbefondsing kan loskom as ’n nodige stap vir die oorskakeling na kommersiële finansiering in die bedryf. Die bevindings dui egter ook op die behoefte van MFIs om aan die belange en vereistes van moontlike kommersiële beleggers te voldoen ten einde nuwe uitdagings te oorkom. Die resultate dui spesifiek daarop dat die mate van organisasie-formalisering en die deursigtigheid van finansiële verslagdoening noodsaaklik is om kommersiële uitleners te trek om in mikrofinansiering te belê. Verder bevestig die studie die redes waarom tradisionele benaderings tot die finansiering van mikrofinansiering nie meer kan werk nie. Daar is wel sekere bekommernisse

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oor die moontlike kompromittering van missie; in besonder is die vraag of die armes wel baat vind by kommersialisasie, en onder watter omstandighede daar na hulle belange omgesien word ten einde die langtermyn sosiale waarde van mikrofinansiering as ’n strategie vir armoede verligting te behou.

Die studie is uitgevoer gegrond op tydreeksdata wat betreklik beperk is. Die aantal maatskappye en die diversiteit word egter as voldoende beskou vir die studie, asook dat die steekproef verteenwoordigendend was van lande regoor Afrika. Die studie gebruik ook die menings van ‘leierdenkers’ as ’n bron van inligting. Personeel van ’n ander kaliber mag verskillende voorstelle gehad het. Persepsies is verkry van kommersiële uitleners/beleggers van mikrofinansieringsprogramme wat in Afrika gebaseer is. Vanselfsprekend behoort enige veralgemening van die KSFe buite die Afrika mikrofinansieringskonteks met omsigtigheid gedoen word.

Hierdie studie is waarskynlik een van die eerste pogings om die moontlikheid van ’n skakel tussen mikrofinansiering en die kapitaalmarkte te ondersoek en dit sal van waarde wees vir MFIs, kommersiële banke, internasionale skenkers en beleggingsfondse wat in belegging in die mikrofinansieringsbedryf belangstel. Die bevindinge dui daarop dat die spoed waarmee die effek van finansiële hefboom in ‘n land toeneem net soveel afhang van die dinamika van die mark as van die ontwikkelingsvlak van die finansiële sektor. Die bevindinge dui daarop dat kommersiële beleggers aangetrek sal word deur goeie finansiële opbrengste, administratiewe doeltreffendheid (opbrengs op bates, voldoende kontantvloei en die bedryfsuitgawe verhouding), deursigtige verslagdoening en duidelike openbaarmaking van inligting, sowel as lae inflasievlakke. Beleggers gee ook voorkeur aan groter, gereguleerde en winsgewende MFIs met ’n lae risikoprofiel vir hulle beleggingsportefeuljes.

Die studie vind sterk ondersteuning vir die hipotese dat die Kommersialisasie-indeks (CI) ’n beter aanduiding van suksesvolle kommersialisasie is as die Leverage Multiplier Added (LMA), gegewe die veranderlikes wat gebruik is. In alle gevalle was daar sterk getuienis dat die CI ’n beter verduideliker is en ’n akkurate voorspeller is van die tweejaartermyn sukses in kommersialisasie soos deur middel van logistiese regressie getoets. Hierdie resultate dui daarop dat die superieure voorspellingsvermoëns van die CI se kommersiële beoordelingsreëls beproef kan word om die sifting van wenners, beleggingsbesluite en ander binêre klassifikasie ondersoeke te lei. Die model kan spesifiek nuttig wees om rigting te gee aan suksesvolle kommersialisasieskemas in Afrika omdat dit MFIs ’n gestruktureerde benadering gee tot die bereiking van volhoubare kommersiële mikrofinansiering.

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Table of contents

Declaration ii Dedication iii Acknowledgements iv Abstract v Opsomming vii

List of tables xii

List of figures xiii

List of abbreviations xiv

CHAPTER 1 INTRODUCTION 1

1.1 INTRODUCTION 1

1.2 STATEMENT OF PROBLEM 6

1.3 RESEARCH OBJECTIVES, QUESTIONS, AND/OR HYPOTHESIS 8

1.4 SIGNIFICANCE OF THE STUDY AND CONTRIBUTION TO KNOWLEDGE 9

1.5 MAIN CONCLUSIONS 11

CHAPTER 2 LITERATURE REVIEW AND CONCEPTUAL FRAMEWORK 14

2.1 INTRODUCTION 14

2.2 THE ROLE OF MICROFINANCE IN ECONOMIC DEVELOPMENT 16

2.2.1 Role of microfinance institutions as financial intermediaries 18

2.2.2 Role of MFIs in poverty alleviation 19

2.2.3 Rethinking the enterprise game 21

2.3 WHY COMMERCIALISE MICROFINANCE NOW? 23

2.3.1 MFIs’ operations, characteristics and challenges 24

2.3.2 Commercial microfinance rationale 28

2.3.3 The concept of commercialisation 31

2.4 AN OVERVIEW OF THE FUNDING ENVIRONMENT AND RELEVANT LITERATURE 33

2.4.1 Introduction 33

2.4.2 Role of commercial finance in microfinance intermediation 34

2.4.2.1 Traditional view 34

2.4.2.2 Commercial view 36

2.4.2.3 Challenges to commercialisation 38

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2.6 BUSINESS FINANCING THEORY AND MARKETS 44

2.7 CRITICAL SUCCESS APPROACH: EXPLORATORY FACTOR ANALYSIS 48

CHAPTER 3 DATA AND RESEARCH METHODOLOGY 51

3.1 INTRODUCTION 51

3.2 PART I: POPULATION AND SAMPLING 51

3.2.1 Part I: Survey design and success factor determination 52

3.2.2 Part I: Survey framework and approach 53

3.2.3 Part I: Factor analysis 54

3.3 PART II: DATA AND VARIABLE DESCRIPTION 55

3.3.1 Part II: Data collection and sample description 56

3.3.2 Part II: Measuring success in commercialisation: conceptualisation of the dependent

variables 56

3.3.3 Level I: Measure of success: leverage multiplier added 56

3.3.4 Level II: Measure of success: commercialisation index 58

3.3.5 Level II: Measure of success: construction of the CI 62

3.3.5.1 Estimating the rating rule 65

3.4 PART II: INDEPENDENT VARIABLE DESCRIPTION AND MEASURES 66

3.5 PART II: MODELING SUCCESS IN COMMERCIALISATION 71

3.5.1 Part II: Introduction to logistic regression analysis 71

3.5.1.1 Random forests techniques 72

3.5.1.2 Factor analytic regression 75

3.5.1.3 Estimating the logistic regression model 76

3.5.1.4 Model evaluation criterion 79

3.6 ORDINARY LEAST SQUARES (OLS) TESTS 80

3.7 SUMMARY AND CONCLUSION 81

CHAPTER 4 EMPIRICAL RESULTS, FINDINGS AND DISCUSSIONS 82

4.1 INTRODUCTION 82

4.2 PART I: DESCRIPTION OF FINDINGS 82

4.2.1 Part I: Factor analysis, interpretation of results 86

4.3 PART II: EMPIRICAL RESULTS 90

4.3.1 Part II: Dependent variable rank correlation results 93

4.3.2 Part II: Relative importance indices for explanatory variables 95 4.3.3 Part II: More investigation on significance of explanatory variables 97

4.3.4 Part II: Logit analysis results 100

4.4.1 Factor analytic logit model 100

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4.4.2.1 Evaluating predictive performance of the classification models 110

4.4.2.2 Sub-analysis logit models 111

4.4.3 Conclusion 116

4.5 COUNTRY MODEL PREDICTIONS 117

4.5.1 Introduction 117

4.5.2 Studying the evolution of commercial funding patterns across countries in Africa: 118 4.5.3 Where are the next portfolio investments in microfinance likely to be found? 121 4.5.4 Country classifications and commercial prediction model 125 4.6 FINANCING CHOICE INVESTIGATION AND MODELS OF FINANCING BEHAVIOUR

FOR AFRICAN MFIS 127

4.6.1 Introduction 127

4.6.2 Understanding financial structure of African MFIs 127

4.6.2.1 Growth and financing 130

4.6.2.2 Financing pattern investigations using regression analysis 135

4.7 SUMMARY RESULTS 139

CHAPTER 5 SUMMARY AND CONCLUSIONS 142

5.1 INTRODUCTION 142

5.2 SUMMARY PART I FINDINGS 142

5.3 SUMMARY PART II FINDINGS 144

5.4 INFERENCES, LIMITATIONS AND FUTURE RESEARCH AGENDA 146

5.5 OVERALL SUMMARY CONCLUSIONS 148

List of sources 150

APPENDIX A LIST OF THE 42 FACTORED SUCCESS ITEMS 161 APPENDIX B CFR-SCORES GENERATION FOR CI 163 APPENDIX C RANDOM FOREST TREE CONSTRUCTION 165 APPENDIX D LIST OF SAMPLE MFIs AND REPRESENTATIVE COUNTRIES 168

APPENDIX E MEP2002 QUESTIONNAIRE 173

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List of tables

Table 3.1: Summary of financial variables and investor criterion 60

Table 3.2: Independent variables description and formulae 67

Table 4.1: Results of mean score importance rating 83

Table 4.2: Distribution of respondents among operational regions 85

Table 4.3: Number of factors and Eigenvalues 86

Table 4.4: Results of rotated factor matrix 88

Table 4.5: Distribution of institutions and observations by country and year 92

Table 4.6: Relationship between CI and LMA 93

Table 4.7: Importance scores for CI 96

Table 4.8: Rotated factor matrix of numeric indicators 98

Table 4.9: Factor analytic logit models (step-wise analysis, three allowed) for total sample 101

Table 4.10: Random forests performance results 104

Table 4.11: Binary logistic regression results: SPSS modeling LMA 105 Table 4.12: Binary logistic regression results: select variables 106 Table 4.13: Binary logistic regression results: full data set 108

Table 4.14: Summary factor solution: variables 109

Table 4.15: Cluster sub-model analysis results 111

Table 4.16: Cluster sub-model analysis results: four select models 113 Table 4.17: Binary logistic regression results: common variables 114 Table 4.18: Binary logistic regression results: CSF sub-model 115 Table 4.19: Binary logistic regression results: best-fit sub-model 116 Table 4.20: Proportion of portfolio supported by donations (quasi-equity financing) over sample

period (1998 to 2003) 119

Table 4.21: Commercial access status and likelihood of success ranking 122 Table 4.22: Rate of correct classification of country prediction models 126 Table 4.23: Common-size part of balance sheet for African MFIs 128 Table 4.24: Growth opportunities and MFI capacity to generate profits 131 Table 4.25: Proportion of MFIs that exceed their maximum growth rates 133

Table 4.26: Ordinary Least Squares regression results 136

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List of figures

Figure 3.1: Classification on CI scale 64

Figure 4.1: Respondents’ areas of expertise 86

Figure 4.2: Chi-square test results between CI and LMA 94

Figure 4.3: Top seven variables 95

Figure 4.4: Factor solution scree diagram 97

Figure 4.5: Most important variable: ROA 103

Figure 4.6: Africa regional commercial funding access 124

Figure 4.7: Africa regional likelihood of success 125

Figure C.1: Out-of-bag error as forest gets larger, M = 2 166

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List of abbreviations

A Assets

ADB Asian Development Bank CBS Central Bureau of Statistics CEOs chief executive officers CFA commercial funding access

CFR Commercial Financing Rating score CGAP Consultative Group to Assist the Poor CI commercialisation index

CIDA Canadian International Development Agency CIs commercialised institutions

CR capital ratio

CSFs critical success factors DT decision trees

E equity

EM equity multiplier EMR equity multiplier rating GDP gross domestic product GNI gross nation income G-R growth-retrenchment I annual inflation IBF interest-bearing funds ICR internal cash ratio

IFC International Finance Corporation IGR internal growth rate

INAFI International Network of Alternative Financial Institutions IPOs initial public offering (for new equity finance)

KIPRRA Kenya Institute for Public Policy Research and Analysis L liabilities

LMA leverage multiplier added LMR leverage multiplier rating LR lending rate

MDGs millennium development goals MEP microfinance experts panel MEs micro-enterprises

MFIs microfinance institutions

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MM Modigliani and Miller NB number of borrowers

NGOs non-governmental organisation N-IBF non-interest-bearing funds NIP net interest position ODA overseas development aid OL opacity level (of information) OLS ordinary least squares OOB out-of-bag

OSS operating self-sufficiency PAR portfolio at risk

POT pecking order theory

PPI preparedness performance index PRF probabilistic random forests PRSP poverty reduction strategy study RE retained earning

RF random forests ROA return on assets ROE return on equity

SGR sustainable growth rate SMEs small and micro-enterprises TAG total asset growth

UK United Kingdom

UNDP United Nation’s Development Programme

UNEP United Nations Environment Programme Finance Initiative US United States (of America)

US$ United States dollar

USAID United States Agency of International Development USB University of Stellenbosch, Business School

WB World Bank

WOCCU World Council of Credit Unions WRI World Resources Institute WSBI World Savings Bank Institute

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CHAPTER 1

INTRODUCTION

1.1 INTRODUCTION

Microfinance is the provision of financial services to the poor and low income. A key focus of microfinance is to respond to the demand for borrowing to support self-employment and small enterprise growth (Khandker, 2005). Microfinance as a new concept in finance and development has endeavoured to develop sustainable enterprises since its birth in the 1970s. For several years, microfinance innovations have been replicated from country to country, each time with renewed enthusiasm and innovation leading to international best practices that have benefited our understanding and guided the practice of microfinance-credit (Stauffenberg, 2001; Rhyne, 2001a; Labie, 2001; Manroth, 2001). Given the ongoing developments in microfinance, there is considerable interest for many microfinance institutions (MFIs) in Africa to keep pace with the changing landscape in the industry.

The microfinance initiative started with two objectives: first to provide access to general financial services targeted to economically-active poor and other vulnerable groups in society, and secondly, to provide access to credit for social and economic empowerment. The best-known part of microfinance is the second objective, and in this study it is referred to as microfinance-credit (Labie, 2001; Elahi & Danopoulos, 2004). Microfinance-credit for purposes of this research is defined as small or microloans meant to develop small (can be tiny) enterprises and income-generating activities often run by the low income groups and the poor (CGAP, 2001; Elahi & Danopoulos, 2004). This part of microfinance has been in use over the years and is a main target for funding by international donor agencies, social investors and subsidised state-run credit schemes. MFIs play an intermediary role in mobilising scarce resources and disbursing microloans to micro-enterprises operated by the poor and thereby expand their choices, and reduce the risk they face (Torkestani & Ahadi, 2008).

However, not all ‘poor’ in society are eligible for microfinance interventions. And besides, poverty is variously defined and exists in several dimensions. Arch (2005) suggests three groups of the world’s poor:

i) working poor, earning money, but below liveable wage;

ii) the poor, with no access to basic services, unutilised skills, but often excluded from the economic system; and

iii) the poorest of the poor, destitute or living below US$1 per day representing desperate cases of poverty.

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Microfinance interventions address the first and second category, namely low income and economically-active poor. Poverty on the other hand can generally be defined as deprivation of human capabilities or a condition of low income, hunger, vulnerability, exclusion and powerlessness (Arch, 2005).

The bulk of microfinance services are microfinance-credit meant for small and micro-enterprises (SMEs or more specifically micro-enterprises (MEs)) and form the main subject of discussion in this study. SMEs/MEs as the recipients of microfinance-credit refer to that part of the poor society that is economically active – that is, able to run and operate income-generating activities. The active poor adopt a sustainable livelihood by identifying small business opportunities, and pursuing them. Their kind of micro-enterprises are very small or tiny informal income-generating businesses, that are managed and operated by entrepreneurs who derive most of their livelihood from the business (Arch, 2005; McKee, 2001a; CIDA, 1998). Most micro-businesses can employ five to seven or more staff including the owner. Over time, vulnerable groups in society have perfected this art (micro-entrepreneurship), which has now become the engine of development in many developing economies and indeed the heart of microfinance.

The success and replication of microfinance programmes worldwide has enabled a proliferation of MFIs that has overly strained the main funding source (Callaghan, Gonzalez, Maurice & Novak, 2007). It is estimated that there are around half a billion people who own small and micro enterprises and only 10 million have access to credit and other financial services (Arch, 2005; Bystrom, 2007). The high growth rate of the microfinance initiative, particularly in developing countries, has triggered such a high demand for finances that funding levels in the industry have not been able to match (Arch, 2005; Bystrom, 2007; Koveos & Randhawa, 2004; Carlos & Carlos, 2001; KIPRRA, 2001). Cull, Dermirguc-Kunt and Morduch (2007) suggest that 40 to 80 per cent of the population in most developing economies lack access to formal banking services. This is particularly of concern when we consider the decreased availability of traditional donor sources of finance, and the uncertain capacity of MFIs to access alternative funds. This has resulted in the need for alternative funding for microfinance besides traditional donor sources (Emeni, 2008; Carlos & Carlos 2001; KIPPRA, 2001).

Funding is a major constraint in microfinance and slows the growth and expansionist activities of microfinance innovation in many developing economies. This is despite the recognition that microfinance has contributed immensely to the creation of sustainable livelihood in poor societies, and micro-enterprise development. The problem is twofold: Firstly, current financing approaches for MFIs have not emphasised access to commercial capital until recently when grants funding became scarce; and secondly, while donations have made enormous contributions to microfinance development and poverty reduction among the poor, attempts to scale up funding from this traditional source has been an uphill task. However, to keep momentum with improvement and

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sustain achievement of the microfinance initiative it now becomes essential to microfinance entrepreneurial activity to focus on attracting commercial finance (Hartungi, 2007; Emeni, 2008; Counts, 2008).

MFIs are currently faced with four sources of funds: i) own sources including internally generated income; ii) voluntary savings (group) mobilisation;

iii) borrowed funds (from friends); and iv) grant support from donors.

Out of these four, grants form the bulk of the supply side of the balance sheet (Jansson, 2003; USAID, 2005). However, subsidies or grants are not available in the quantities necessary to fuel the growing microfinance sector (Cull et al., 2008). Commercial sources of funds have on the other hand not been explored fully, yet they can play a greater role in relaxing the funding constraints facing MFIs. Nevertheless, since 2000 there has been a rapid growth in commercial investment by various investor funds that tend to be more commercially oriented. This source of finance is however driven by different considerations than those for donor funding thus making it more interesting to study (Sengupta & Aubuchon, 2008; Arch, 2005).

It is argued that commercial sources are a viable alternative for providing massive long-term resources for growth (Daley-Harris, 2009; Bystrom, 2007; Lewis, 2008). Hence this research aims to suggest that successful commercialisation of microfinance will provide greater funding diversification for development finance. The author therefore looks at critical success factors for tapping into commercial funds to microfinance in Africa and suggests drivers that could unlock investment in this critical area.

It is the objective of this research study to establish the factors necessary to attract commercial capital for MFIs, particularly those based in Africa. The establishment of these factors is important in as far as it helps in financing reformation of the microfinance industry.

The study explores the concept of commercialisation and seeks to answer the question: Have MFIs attracted commercial capital flows as a solution to their financing problem? and if so, What factors were associated with African MFIs that were found to be successful in accessing this kind of capital?

The study also investigates country likelihood of future success with commercial microfinance as an alternative funding strategy; as well as assesses the viability of this potentially important source of funds for MFIs. Given the financial needs of the microfinance sector and its huge growth potential, commercialisation (defined as the funding of an MFI's expansion operations and lending portfolio with commercial finance) has a role to play in the sector’s future development.

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This study is significant because MFIs have reached a maturity stage whereby no further growth or meaningful impact can be achieved without access to an alternative limitless source of capital. CGAP (2007) suggests that, to serve massive numbers of the poor with high-quality financial services MFIs have to tap into commercial sources of funding and deposits. MFIs in this study refer to financial intermediaries (of all types regardless of legal status) that have developed a unique focus and proven methodology of providing access to financial services to micro-enterprises (MEs) and the poor in general.

The key concern to MFIs with regard to commercialisation is the risk of inability to succeed in attracting commercial sources of finance. The majority of MFIs lack the management capacity to attract and absorb commercial capital, which often requires complex capital structure decisions (CGAP, 2007; USAID, 2005). The lack of exposure and experience in dealing with commercial markets is also another concern (Daley-Harris, 2009). Another commonly argued barrier is the lack of scale or size to absorb big money and lack of enough profitability (Daley-Harris, 2009; Callaghan, Gonzalez, Maurice & Novak, 2007). While this seems to present a dilemma, the good news is that there is a growing commercial investor interest (both in amount and risk tolerance) in the sector. Statistics show that the sector attracted 59 investment houses and donors acting as lenders/investors in 2005 (USAID, 2005; De Sousa, Frankiewicz, Miamidian, Steeven & King, 2004). This group of new money investors altogether made available 1.7 billion United States dollars (US$) by 2005.

A major motivation in studying commercialisation is also the fact that while investors can be said to be viewing microfinance with interest, a worrying dimension is that commercial investment is focused on regions and high performing MFIs (Daley-Harris, 2009; Cull et al., 2008). Regions or countries regarded as safe destinations attract more commercial finance than others such as Latin America, Eastern Europe and India. A study on commercially-oriented finance revealed that 87 per cent of all available investor funds went to Latin America and Eastern Europe alone (USAID, 2005). It is suggested that Africa and Asian countries do not produce enough signals for commercial investment attraction; yet they have the largest microfinance programmes (Delay-Harris, 2009; Meehen, 2004). The problem for African MFI’s ineligibility lies partly in the fact that some institutions mobilise insufficient member savings (particularly in West Africa) while qualifying MFIs continue to receive some donor funds, thus distorting their focus on commercially-oriented finance. This suggests that, Africa has special funding needs – a fact that provided the motivation for the author to investigate the factors that can enable the continent to attract commercial investment.

It is obvious from the above-mentioned facts that a lack of access to continued funding, among other constraints, is the greatest threat in the microfinance industry to date. This threat is even more real for the African region which is considered by investors as unfavourable due to low

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returns (Daley-Harris, 2009). This greatly concerns microfinance advocates as much as it worries the MFIs and the beneficiaries of their financial services. International development aid in microfinance is no longer able to meet the huge funding gap of about US$300 billion (Meehan, 2004; Counts, 2008). It is estimated that the sector has an annual growth rate of 15 to 30 per cent and only an insignificant portion of the total demand has been reached (Bystrom, 2007). This clearly presents a huge demand and a big challenge unless private capital is drawn into the sector. MFIs therefore need an alternative and a clear financial planning strategy, so as to remain relevant in reaching a significant population of the poor with financial services.

The main challenge is whether MFIs, given their non-profit background and lingering influence of donor-subsidy-financing, can really attract and absorb commercial capital. Certainly the road map for gaining access to commercial sources requires a demonstration of consistent profitability. It is suggested that commercialisation (elsewhere referred to as access to private capital) of microfinance will pave the way for the entry of private capital which will lead to expansion of constrained funding into the untapped financial markets.

Other challenges have to do with lack of relevant information due to scant and little research guidance in this area. For instance, much of the information available on this subject area is usually informal, non-scientific or simply educated estimates (Callaghan, Gonzalez, Maurice & Novak, 2007). This research study, however, sheds good light on the issues. In this regard, the microfinance capital market is being informed by well-researched information to guide the sector’s take-off.

Using both primary and secondary data, the author undertook a comprehensive research study on the subject area of commercialisation for African MFIs. First, the study sought to identify critical success factors (CSFs) from the perspective of commercial lenders. In particular, the results show that the extent of organisational formalisation and transparency in financial reporting are linked. These two factors are identified as absolute essential in making commercial lending decisions by private investors. Other key determinants of credit evaluation decisions are adequacy of cash flows to service commercial loans, good portfolio quality and sound financial management practices (Arvelo, Bell, Novak, Rose & Venugopal, 2008). The top list also includes a reputable board that offers effective governance.

These results lead to a realistic critical success factors (CSF) checklist for self-assessment of an MFI's progress in commercialisation. They provide CEOs of MFIs with valuable guiding principles for attracting the financial markets. A test of consistency between perceptions held by surveyed respondents and what they practiced, found that there is a direct correlation between factors perceived to be important and actual criterion used by lenders to advance loans to MFIs. The CSF

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thus identified compare well with the considerations cited as evaluation criteria in real-world industry practice.

Secondly, the study attempted to validate the CSF results using financial variables from 103 African MFIs in 21 countries that have been involved in raising commercial capital since 1998. Based on firm-level data, the results confirm the perceptions of commercial lenders’ perspectives. On the whole, the findings suggest the importance of good financial returns and administrative efficiency (ROA, cash-flow adequacy and operating expense ratio), transparent reporting and information disclosure and clarity, as well as inflation levels and lending rates in the country as key requirements of prospective commercial investors in microfinance. This research evidence is instructive of widened financing options for MFIs and capacity to relax growth constraint in the industry.

The cross-country data also helped in the examination of financial leverage per country, and it was found that an increase in financial leverage depends as much on the dynamism of the market as it does on the level of development of the finance sector. Attraction and future access to commercial funding differ across countries in the sample. The results indicate that investors will also be looking for larger, regulated and profitable MFIs with a low risk profile on their loan portfolios. Finally, the study developed and estimated a commercialisation success model for guiding MFIs on how to tap private capital, as well as ways of establishing financing connectivity between viable microfinance investments in Africa and commercial investors. The results contribute to the body of knowledge in development finance and MFI commercialisation schemes in Africa.

The remainder of the dissertation is structured as follows: The next section describes the statement of the problem, research objectives and significance of the study. Chapter 2 examines the existing theoretical and empirical literature in which this study can broadly be placed. In Chapter 3, the data and sample is described and in addition details of the conceptual framework and measurement of the dependent variable. The success model used in the analysis is also presented along with success factor identification techniques. Chapter 4 presents the main empirical tests and findings, and the relative performance of the two-year prediction model of successful commercialisation. Finally, Chapter 5 gives the summary, examines the implications of the findings and suggests some further areas of research into the topic.

1.2 STATEMENT OF PROBLEM

Despite the success of microfinance initiatives in numerous countries worldwide, a significant percentage of the micro-enterprise market has not been reached due to funding problems. The potential market size and funding gap reveals a need in excess of donor funding available for growth in portfolio and expansion of microfinance activities. To exploit this opportunity, as well as

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serve a large number of poor households, microfinance institutions will need an alternative source of funding.

While donations have made an enormous contribution to microfinance development, attempts to scale up funding from this traditional source have been an uphill task. It is limited in amount and unavailable for many institutions. The constant challenges that confront practitioners/MFIs every day include how to finance the many microfinance programmes on the ground, how to finance eminent growth and achieve mass outreach and how to respond to competitive pressures on funding and customer demands for loans. With this predicament, the future course for microfinance is at a crossroad!

In an effort to achieve the above desired outcomes and in recognition of declining donor funds; MFIs worldwide are establishing links with formal financial systems, in search for alternative sources of funding. And this no doubt brings commercialisation into the equation to build the bridge. To reach a significant percentage of the micro-enterprise market, this indeed may be the only sure way of making a meaningful contribution to much needed economic growth and poverty reduction.

Commercialisation is increasingly becoming the only viable business option for MFIs to widen their funding base and options. However, this new paradigm shift raises the stakes for microfinance business in Africa in particular. The major concern is whether African MFIs have what it takes to enter this new evolving financing phase? And secondly, whether these institutions can meet the pre-conditions for success and sustainable migration from donor-dependency? Commercial banks have been reluctant to become involved because of the unconventional practices of microfinance: Small loans, doing business with the poor assumed to have no purchasing power, lack of collateral and nil requirement of security for advances and generally a risky lending environment. For the investment community, microfinance does not present a clear investment asset class. Conventional asset classes, for example, do not mix social and profit motives – a key characteristic of microfinance. This creates confusion and yet another problem for microfinance where the heart of its existence becomes its biggest hindrance for attracting new investors.

This presents the questions that are at the centre of this research study:

• What is the password for unlocking private capital resources for economic growth and development for microfinance institutions in Africa?

• Can the funding gap be reduced; and

• Is the financial markets the answer to the financing constraint faced by MFIs?

• Will an understanding of the general characteristics or perspectives and roles of this prospective group of new capital providers in microfinance shed great light and help relax the funding constraint in the sector?

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These and other related questions remain to be answered and form the driving force for this study and problem. A related issue on possession of the necessary ingredients to attract private capital is: How do MFIs know that they can succeed in raising commercial capital given the costs involved in doing so? This issue is yet to be addressed.

It is this lack of guidance and scientific information that has led to the search for a measure of success in commercialisation in this study. The development of a prediction model is seen as a quick solution (‘temperature gauge’) to help in the assessment of an MFI’s ability and capacity to succeed in accessing commercial capital, and also serves as an early warning system of the likelihood of the successful avoidance of failure. For investors the model can be used to reduce screening costs and thereby enable quick identification of investable MFIs to avoid unnecessary experimentations.

1.3 RESEARCH OBJECTIVES, QUESTIONS, AND/OR HYPOTHESIS

It is clear, following the above rationalisation that the method of funding microfinance is a problem and poses a threat to the success of microfinance programmes and initiatives. This conclusion is being drawn while microfinance has expanded so much, has strong political support as a development initiative (the Nobel prize for peace in 2006 was given in honor of microfinance), and has raised considerable interest in the private sector in the last ten years. Can a sector that offers so much hope for the future development of micro-enterprise and poverty alleviation be left to die? The bottom line is that the microfinance sector desperately needs financial support from a sustainable financial system for growth and expansion to be able to continue the good work. The aim of this research study is to provide answers to the financing problem of MFIs, in response to the above call. The study focuses on examining the evolution from donor funding (and support) to alternative financing mechanisms and tries to establish if commercialisation is a viable option. Specifically, the study seeks to:

i) Identify and highlight critical success factors (CSF) for tapping commercial sources of funds and for enabling MFIs to effectively handle the switch to private sources of capital. These factors define minimum pre-conditions under which an MFI can consider commercialisation as a viable alternative source of funding. The main research question here is: What are the CSFs that underpin success in commercialisation of microfinance for African MFIs?

ii) Examine both process and dynamics of commercial microfinance, particularly focusing on efforts made by African MFIs. In theory commercialisation provides a mechanism for accessing alternative leveraged funds. The key question is: How successful has this option been as a financing strategy, and what are the lessons learnt? The examination will help suggest how MFIs can break free from donations.

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iii) Shed some light on financing choices of MFIs between 1998 and 2003. The research questions will be: When MFIs need additional finance, how do they make financing decisions? Are there any preferred choices? What financial structure patterns exist, and what financing theory do these seem to support?

iv) Develop a commercialisation success model for tapping commercial funds, validate it and assess its suitability in predicting success in commercialisation.

v) Explore the hypothesis of growth opportunity. It is argued that fast growing firms often use debt to grow. What is supporting growth for African MFIs? The other question to be addressed is: Is the industry in Africa growing and at what speed?

vi) Explore the feasibility of integrating the microfinance sector with the financial markets, with special emphasis on African MFIs. Specifically, to undertake a comparative cross-country analysis of the likelihood of success with commercial microfinance, on the basis of gained access to vast amounts of funding and develop the pathway for such access.

vii) Investigate if commercialisation destroys long-term social value of microfinance initiative. This research tries to answer the question whether ‘commercialisation causes mission drift’; that many believe to be true for a long time, but the debate has had no conclusive evidence. It is strongly argued that having concern for the poor is a critical ingredient for microfinance practice and poverty reduction. And the poor are likely to suffer from the effects of commercialisation. Do CEOs sacrifice the social goal of microfinance in the quest for financing? Is commercialisation then good for the poor or does there exist a conflict between the commercial and social objectives of microfinance?

1.4 SIGNIFICANCE OF THE STUDY AND CONTRIBUTION TO KNOWLEDGE

The research findings include: Identification of critical success factors that drive effective commercialisation; revealed feasibility of commercialisation strategy in Africa and the pathway to successfully link with the wider financial markets for microfinance institutions. The empirical findings add to the understanding of financing relationship cementing factors between commercial lenders and MFIs, besides providing insight into factors associated with successful commercialisation of microfinance in Africa. Identified factors will form the springboard for commercialisation success and hence ease the funding problem as the financing alternative base widens. Available knowledge also improves the capacity to commercialise and/or tap and attract private investment funds for MFIs.

The growing scarcity of donor funds and increasing MFI competition for funding has sparked increased interest from the financial markets. However, many MFI managers do not understand the most important factors that drive successful attraction of commercial funding. On the other hand, investors either have no access to investment information or a lack of understanding of the

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strength of microfinance. Therefore it was worthwhile to launch an investigation of CSFs for implementation of an alternative source of finance for microfinance.

The development of a prediction model helps to assess an MFI’s ability and capacity to succeed in accessing commercial capital, and also serves as an early warning system of the likelihood of successfully avoiding failure. The model provides a framework upon which to build strategies for pro-poor commercialisation. Identification of good investment proposals by investors now becomes easier with an existence of an accurate temperature gauge and an instrument to measure in advance an MFI’s capacity to handle commercial microfinance.

Policy makers and donors alike, plus an increasing number of practitioners, now see commercialisation as one of the ways of broadening the financial possibilities available to MFIs, and of leveraging their internal resources (and of course limited donor resources) for meeting growth and development objectives. Commercialisation is inevitable given the insufficiency of donor funding for microfinance development. A main contribution of this study is the proof that this option is indeed feasible. This is because the financial markets can be more dependable in the long run and are capable of offering vast amounts of funding, for mass outreach. With favourable conditions, commercialisation can substantially and sustainably increase the volume and range of financial services for micro-enterprises in Africa.

The capital markets are catching up with the idea of the need for well-researched information to guide microfinance sectors’ take-off. This study therefore attempts to offer a comprehensive research investigation on the subject of commercialisation and the much needed successful approaches of attracting commercial capital.

Results of comparative analysis of country likelihood to succeed will be useful as a benchmark for building a competitive environment for performance standards and excellence in commercial microfinance. This will be useful in the sharing of knowledge and practices to avoid pitfalls as the face of commercialisation evolves in each country. The investigation of the financing behaviour of commercialising MFIs in Africa and extent of financial leverage shows whether the MFI has the right balance between debt and capital and how much room is left for debt absorption. This knowledge will guide MFIs in observing the right capital ratios as per their regulatory environment as well as help them in maximising the benefits of debt financing.

Investigations on the impact of commercial microfinance on long-term social value of microfinance indicate limited evidence that MFI size and social variables will play any role in differentiating who will be funded and who do not attract commercial capital. Not surprising, the findings suggest that commercialisation has a tendency to negatively motivate CEOs/managers to sacrifice long-term goals of the microfinance initiative. The study also reveals that concerns on mission drift are real;

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in particular that the poor benefit less from commercialisation, and under some circumstances it may actually hurt them.

1.5 MAIN CONCLUSIONS

The microfinance industry has experienced tremendous growth, but current enthusiasm is often tempered by a limitation of development finance. Firstly, because of constrained donor funds, and secondly, because MFIs find it difficult to obtain funding from the larger financial community that views such investment as unattractive and high risk.

There is a growing shortage of donor funds (which is the main traditional source of capital for MFIs) and this study develops effective success strategies that promote alternative funding sources in order not to limit the potential for microfinance in economic development. It is now a reality that microfinance financing models relying and focusing on donor financing have limitations and are not able to reach more poor societies that are in dire need of financial services. This study presents an alternative-financing model for MFIs that would like to explore and leverage on scarce donor funds. The model encourages investment in and development of microfinance, and identifies criteria used by commercial lenders and other capitalists when considering funding of an MFI. The model therefore offers an alternative source of capital to institutions at the cutting edge of enterprise development and commercial market reforms.

The need to satisfy commercial investor funding requirements by microfinance practitioners is increasingly pressing, given the urgency for microfinance objectives of poverty alleviation and development of the small and micro-enterprise sector manned by the poor. This research derives and highlights ten critical success factors (CSF) that enable a realistic checklist for self-assessment of MFIs for attractiveness to investors and progress into a commercialisation strategy. They reflect ten financing goals for microfinance institutions in raising additional funds from commercial fund markets. This pre-screening tool will enable MFI management to realign critical success strategies and tactics to correct identified deficiencies and control for disappointments arising from premature moves for commercial funds drive.

The list of CSFs identifies the following key commercial lenders’ criteria: • Extent of MFI formalisation and transparency in financial reporting; • Viability of investment in microfinance;

• Microfinance practice; and

• Extent of product delivery innovations.

It is hoped that the transparency afforded by CSFs will help to change the reputation of microfinance to financiers and bring the possibility of a linkage between microfinance and capitalists. The bridge thus created will mean gained access to more financing options, and

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industry freedom from donor syndrome and funding trap. This communication breakthrough will finally provide a necessary platform for the switch to commercial finance.

The cross-country data analysis offered research evidence suggesting lack of clarity and scarcity of information on performance as key deterrent to private investors. Other significant predictors for successful commercialisation of microfinance identified include profitability, capacity to repay commercial debt (cash-flow adequacy), fast growth in MFI and inflation. This implies that commercial lenders can know in advance of an MFI’s ability and capacity to handle commercial microfinance. These empirical findings add to the understanding of the financing relationship cementing factors between commercial lenders and MFIs, besides providing insight into factors associated with successful commercialisation of microfinance in Africa.

The results indicate the emergence of new finance sources for development and poverty reduction, widened financing options for regulated MFIs and capacity to relax growth constraint in the industry. This study has therefore developed the pathway through which an MFI can become part of the financial landscape and identified the factors that underpin success in commercialising microfinance institutions. The model developed here can be useful within organisations to establish baseline measures for future prediction of success in commercialisation. However, investigations of the impact of commercial microfinance on the long-term social value of microfinance indicate that although commercialisation offers new opportunities for accessing fresh capital, there are some genuine concerns on mission drift, in particular whether the poor gain from commercialisation. It will take serious commitment from an MFI to preserve the long-term social value of microfinance as a poverty reduction strategy.

The developed country prediction models are particularly informative for investors. According to this study, more than half of sample MFIs are enjoying access to commercial finance while obtaining donations. However, the CI predicts Africa as a whole is a continent in transition from donations, but struggling to be successful in commercialisation. North African country MFIs are more likely to be successful in future, followed by East and then West Africa. Each of these groups of countries presents an opportunity for investors and indicates likely destination for commercial funds. These results obviously imply that it is possible to develop a uniform commercial success prediction rule for MFIs in Africa that would give useful information to investors. The model will also be useful in guiding successful commercialisation schemes in Africa in that it provides MFIs with a structured approach for achieving sustainable commercial microfinance.

Although this is the first attempt to model commercialisation, these results suggest the CI commercial rating rule has superior predictive abilities that could be explored to guide screening efforts for winners, investment decisions and other binary classification investigations. This

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research found strong support to the hypothesis that ‘the CI is a better measure of successful commercialisation than the LMA (leverage multiplier added), given the variables used’.

This research study investigated if there are identifiable financial structure patterns and how changes in total assets have been financed for African MFIs over the sample period. Exploratory results on financing behaviour seem to indicate a pecking order that prioritises donations/retained earnings, savings and use of commercial debt. The results show that about 70 per cent of financing that flows to African MFIs currently come from commercial sources. The equity multiplier indicates that these institutions are now leveraging their own funds three times. That is, every dollar of equity generated US$3.12s from external (commercial) sources in 2003. Thus commercial debt has more claims over MFI assets in Africa! It is now reality that MFIs can and are broadening financing possibilities, and that the main source of financing for microfinance in Africa is commercial capital. These results have implications for development of commercial microfinance in the continent.

The study reveals that the majority of African MFIs could not finance their growth themselves and did not get enough short-term finance for the same, over the sample period of 1998 to 2003. They had to rely on external finance for their growth needs. And, only 37 per cent of the sample (MFIs in eight countries) have the ability to generate sufficient cash flow from performing assets to cover all costs and maintain the value of capital. The results indicate that 90 per cent of MFIs on average

have had high growth opportunities, fuelling fast growth and a vibrant microfinance business. To finance this fast growth, there was greater use of financial leverage over time that defined a clear trend of commercialisation in Africa. That is, the replacement of donated equity with interest-bearing funds.

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CHAPTER 2

LITERATURE REVIEW AND CONCEPTUAL FRAMEWORK

2.1 INTRODUCTION

For a long time now, the main source of financing for the microfinance sector has been dominated by development aid (non-commercial sources of capital). Understandably, financial markets or private capital has played a minimal role in this poverty focused industry which continues to thrive on finance sources whose allocation is based on development aims as opposed to profit maximisation. However, if the sector is to relax current financing constraint on growth and meet its goal of serving a large portion of the world’s poor with much needed financial services, it must develop access to commercial capital as an alternative financing strategy.

Researchers are in agreement that MFIs have the capacity to pave the way for broad access to finance for active poor and low-income societies (Cull et al., 2008). Active poor refer to poor people who have the capacity to work and who can undertake activities that generate stable incomes. They are deemed poor because they cannot unleash their capabilities due to one or several deprivations. The term ‘poor’ in microfinance as used in this study refers to that part of the society or households that earn less than US$1 per day, and are economically active. This definition includes vulnerable groups that may be above the international poverty line, but can slip into poverty, but excludes destitute cases that are at the bottom of the economic pyramid (bottom ten percentages below the poverty line).

There is a significant net demand for financial services by the poor in many parts of the developing world. Arch (2005) suggests that fewer than two per cent of the worlds poor have access to financial services other than traditional money lenders. And out of the 500 million people who own small and micro businesses, only 10 million have access to credit and other financial services. This undoubtedly leaves a large portion of the population not being served with financial service products. The formal banking system has not been able to fill the gap owing to various constraints including the fact that the poorer segment of society is associated with the perception of high risk (Koveos & Randhawa, 2004).

Microfinance institutions (MFIs) have established themselves as the financial intermediaries for the poor. In this regard they have developed and delivered financial services in the low-end market for decades with success. Originally funded primarily by international donors and public agencies, microfinance is generally agreed to be pro-poor, and its role as a policy tool for effective and sustainable poverty reduction is not questionable (Hartungi, 2007; Beck & Fuchs, 2004; Stern, 2001; Beck, Dermirguc-Kunt & Levine, 2004; ADB, 2000; Klasen, 2005). Indeed, poverty alleviation strategy and achievement of millennium development goals (MDGs) in many developing countries

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in Africa very much depend on the success of microfinance as a business model and other market-based approaches to poverty reduction and development. The rationale behind this argument is that microfinance aids in improved access and efficient provision of financial products that enable the poor to manage and build their asset base gradually for improved quality of life.

Although microfinance has such a huge potential in poverty alleviation and holds a great promise for the poor, particularly in Africa, its funding approach, sandwiched between donations and a transition to commercial sources, suffers from donor fatigue. A recent Consultative Group to Assist the Poor (CGAP) study (De Sousa-Shields & Frankiewicz, 2004) reveals that the volume of grants and soft loans from bilateral and multilateral donor agencies, defined in this study, within the context of microfinance as “non-official ODA” (overseas development aid) stands at US$2.32 billion. The contribution from commercially oriented and private foreign capital is given as US$1.68 billion. The above figures put the global supply for the sector at about US$4 billion (Meehan, 2004; De Sousa-Shields & Frankiewicz, 2004). Hence the majority of the sector’s risk capital has, and continues to come from the development community whose supply has been outstripped by rising demand, now estimated at US$300 billion (Meehan, 2004).

This demand is raised by about 150 to 350 MFIs which are regarded as top performers, out of the possible known 10 000 MFIs worldwide (Arch, 2005). It is argued, that less than 3.5 per cent of all MFI groups represent the only investable group in the conventional sense. However, although this number may seem to be small, microfinance has a reputation that is unequalled in financial services history. The strongest MFIs have reflected profitability and returns that surpass that of their distant cousins in commercial banking (Callaghan et al., 2007). Many MFIs can boast of a return on equity of no less than 15 per cent. This kind of profitability, and the lack of funding in the sector, has stirred great interest among the investment community as well as a source of concern for the promoters of microfinance.

Microcredit in particular requires rapid access to leveraged finance and broadening of strategic choice and growth of programmes. This new direction is essential if MFIs are to sustain their consolidated vision and operations in the foreseeable future. At this stage of rapid growth microfinance needs to identify and emphasise value-maximising strategies. A commercial approach to microfinance has the potential to unleash renewed momentum.

The above-mentioned postulation underscores the need for MFIs to seek to be part of the formal financial system so as to attract funding from abundant commercial sources. With the knowledge and experience built over the years, microfinance has proved its feasibility and value.

Figure

Table 3.1:  Summary of financial variables and investor criterion: CI financial ratio variable  description and predicted relationship with commercialisation
Figure 3.1: Classification on CI scale
Table 3.2: Independent variables description and formulae  Predictor
Table 4.1: Results of mean score importance rating
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References

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